United States: Proposed DOL Regulation Will Provide Relief From Fiduciary Liability For Investments In "Qualified Default Investment Alternatives"

The Department of Labor (DOL) has issued proposed regulations implementing the provision of the Pension Protection Act of 2006 (PPA) that expands the relief available to plan fiduciaries under Section 404(c) of the Employee Retirement Income Security Act of 1974, as amended (ERISA), to include relief from liability for the investment of a plan participant’s assets in a "qualified default investment alternative" in the absence of investment direction from the participant. The proposed regulations, which are required to be finalized no later than February 17, 2007, aim to make it simpler and more attractive for sponsors of individual account plans to adopt automatic enrollment provisions and to allow fiduciaries of such plans (and other participant-directed individual account plans) to select default investments funds that strive to achieve long-term capital appreciation as opposed to mere preservation of capital.

This Alert describes the conditions set out in the proposed regulations that must be met in order for fiduciaries to receive the expanded ERISA section 404(c) protection provided under the PPA and the types of investments that will be treated as "qualified default investment alternatives" under the DOL proposed regulations.

Prior to enactment of the PPA, fiduciaries were potentially liable for a participant’s plan investment losses unless the participant exercised active control over the investment of his or her account. Consequently, in the absence of participant investment directions, plan sponsors and fiduciaries typically would provide for the investment of a participant’s plan account in a conservative default investment, such as a money market, fixed income or stable value fund.

The specter of potential fiduciary liability was also a deterrent to the adoption of automatic enrollment provisions for defined contribution pension plans. Before the PPA, a participant who was automatically enrolled in a plan was not deemed to have exercised control over the assets in his or her account if the participant failed to provide investment directions for such assets. As a result, many plan sponsors would choose not to provide for automatic enrollment in their plans. If a plan sponsor did have an automatic enrollment provision in its plan, the assets of those participants who did not assume investment control would typically be invested in money market, fixed income and stable value funds so as to minimize the risk of potential liability for investment losses. Such conservative default investments preserve capital, but do not achieve long-term capital appreciation.

Another situation where fiduciaries have potential liability for losses in a participant’s account is when investment options available under a plan are changed. In such event, fiduciaries have to choose whether to "map" a participant’s investment in the eliminated fund to an equivalent fund or transfer the participant’s investment to a default fund, which would often be the same type of conservative fund described above.

Under the proposed regulations, a participant in a participant-directed individual account plan who does not provide the plan fiduciary with investment directions will be treated as having exercised control over the assets in his or her account for purposes of ERISA section 404(c) provided that the participant’s account is invested in a "qualified default investment alternative." By treating the participant as having exercised investment control, the plan fiduciaries will generally be protected from liability for any losses that result from investing the participant’s account in the qualified default investment alternative. The proposed regulations describe what constitutes a qualified default investment alternative and six conditions that must be met in order for plan fiduciaries to enjoy the expanded relief from liability provided by the PPA. As is the case with all investment alternates offered under an ERISA section 404(c) plan, plan fiduciaries will remain responsible for the prudent selection and monitoring of the qualified default investment alternative, and any investment managers for such alternative.

The proposed regulations set out the following six conditions that must be met for a fiduciary to qualify for relief from liability for a participant’s plan losses arising from investment in a default fund.

• First, the participant’s assets must be invested in a "qualified default investment alternative" (as defined below).

• Second, the participant must have been given the opportunity to provide investment instructions, but failed to provide such instructions.

• Third, the participant must receive a minimum of 30 days notice before an investment in a qualified default investment alternative is made and additional notices at least 30 days prior to the start of each subsequent plan year. The notice must be written in so as to be understood by an average plan participant and must contain –

• information on when a participant’s assets will be invested in a qualified default investment alternative;
• a description of the qualified default investment alternative, including investment objectives, risk and return characteristics and fees and expenses;
• a description of the participants’ right to redirect the investment of the assets to another investment alternative available under the plan, without financial penalty;
• an explanation of where participants can obtain investment information regarding such other available investment alternatives.

• Fourth, the terms of the plan must provide that any materials relating to a participant’s investment in a qualified default investment alternative that the plan receives will be provided to the participant.

• Fifth, each participant whose assets are invested in a qualified default investment alternative must have the opportunity, at least once every three months, to transfer those assets, in whole or in part, to any other investment alternative available under the plan, without financial penalty.

• Sixth, the plan must provide participants the ability to invest in a "broad range of investment alternatives" within the meaning of the DOL regulations under ERISA section 404(c). Thus, the plan must offer at least three diversified investment alternatives with materially different risk and return characteristics that, in the aggregate, enable the participant to achieve a portfolio with risk and return characteristics within a range appropriate for the participant.

For purposes of the relief provided under the proposed regulations, a qualified default investment alternative is an investment alternative that meets each of the following requirements.

• It must not hold or allow the acquisition of employer securities, except for certain employer securities held or acquired by an investment company registered under the Investment Company Act of 1940 (1940 Act) (or similar state or federally regulated pooled investment vehicles) and certain employer securities held in a managed account that were acquired as matching contributions or were previously acquired pursuant to a participant’s directions prior to the account becoming a managed account.

• It must not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer, in whole or in part, assets from the qualified default investment alternative to any other investment alternative available under the plan.

• It must either be managed by an "investment manager" within the meaning of section 3(38) of ERISA or be an investment company registered under the 1940 Act.

• It must be diversified in order to lessen the likelihood of large losses.

• It must consist of one of following three types of investment products –

• Life-Style or Target-Retirement Date Fund, which provides changing rates of long-term appreciation and capital preservation through a mix of investments in equity and fixed income investments based upon the participant’s age, target retirement date or life expectancy.
• Balanced Fund, which provides long term appreciation and capital preservation through a mix of investments in equity and fixed income investments a level of risk targeted at what is appropriate for participants of the plan as a whole. Under this alternative, the age, risk tolerances and investment preferences of individual participants need not be taken into account.
• Professionally Managed Account, under which an investment manager invests assets in a combination of equity and fixed income investment offered through investment alternatives available under the plan, based on the participant’s age, target date of retirement and life expectancy.

The PPA requires the DOL to issue final regulations on qualified default investment alternatives no later than February 17, 2007. It is expected that the final regulations will include substantially similar conditions and requirements as set out in the proposed regulations, with only minor changes. For example, given that one of the stated purposes of providing relief to fiduciaries for investing in qualified default investment alternatives is to enhance retirement savings, it is probably a safe bet that the final regulations will not add money market funds or other conservative "capital preservation" investments to the roster of qualified default investment alternatives.

Accordingly, plan sponsors and fiduciaries that currently provide conservative default investments funds that are geared solely to preservation of capital, such as money market and fixed income funds, should consider switching to a qualified default investment alternative in order to take advantage of the new safe harbor. Since the final regulations are only a few months away, now is the time for plan sponsors and fiduciaries to start investigating and evaluating appropriate qualified investment alternatives to use as their defaults.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.